The federal funds rate, or the interest rate that U.S. banks charge each other for overnight loans, is the benchmark rate for many short-term and long-term interest rates in the United States. A reduction in the federal funds rate, often times (though not always), decreases the interest rate on credit cards, automobile loans, and mortgages. Lower interest rates encourage consumers to spend and businesses to build new offices and purchase computers, machinery, and software. A boost in consumption (e.g. buying new clothes) and investment (e.g. building new offices) (with the added benefit of lowering the value of the dollar and thus boosting U.S. exports) spending are exactly what the economy needs when it is slipping into a recession caused by sudden drops in overall spending. Though the U.S. economy is NOT officially in a recession, the Federal Reserve forecasts “slowed growth” and would like to cut rates just-in-case.

The previous explanation shows how the Federal Reserve could use monetary policy to minimize the depth and length of a recession. However, what is less well known is the process with which the Federal Reserve is able to manipulate the federal funds rate. Essentially, the Federal Reserve lowers the federal funds rate by expanding the money supply. This is easier said than done.

First and foremost, the Federal Reserve does NOT print new dollar bills. So how is it able to create new money? There are two main forms of money—cash in circulation and checking deposits held in banks. Separate from the money supply are “reserve accounts” that commercial banks are required to have at the Federal Reserve. These reserve accounts hold cash for the commercial banks in case depositors cash-out some of their deposits.

The Federal Reserve can expand the money supply by expanding the amount of deposits held in the U.S. commercial banking system. One way to do so is to purchase U.S. government bonds issued by the U.S. Treasury department. When the Federal Reserve purchases government bonds from commercial banks, it takes bonds out of circulation and electronically credits reserve accounts. U.S. commercial banks armed with more cash reserves will issue new loans which are then deposited back into the banking system. This method effectively increases the dollar amount of checking deposits in the economy, and hence, expands the money supply.

Discussion Questions

1. Suppose U.S. commercial banks are highly reluctant to issue new loans even if they are armed with more reserves. How would this impact the Federal Reserve’s ability to expand the money supply and lower the federal funds rate?

2. Republican presidential candidate, Ron Paul, believes that the Federal Reserve “debases and depreciates” the currency through its manipulation of the money supply. In fact, he wants to abolish the Federal Reserve altogether. Using the definition of the money supply and the relationship between interest rates and unemployment, how could the money supply be “pro-cyclical” without the Federal Reserve?

What’s a fiscal authority to do?

As Greg Mankiw recently pointed out and Wall Street Journal reporter David Wessel was quick to observe nearly a month ago, the actual federal funds rate has been trading below the Fed’s target federal funds rate of 5.25%. The federal funds rate is the rate at which banks borrow from one another overnight, and it is the key benchmark interest rate for monetary policy. The Fed targets a relatively low, or loose, fed funds rate in order to encourage borrowing, speed up economic growth, and avoid recession. The Fed targets a neutral rate when it wants neither slower nor faster growth than the economy is currently experiencing. The Fed targets a relatively high, or tight, rate when it wants to discourage some borrowing, slow the pace of economic growth, and ensure price stability (low and stable inflation).

According to Mankiw, the actual fed funds rate averaged 5.02% during August—23 basis points lower than the target—while in the preceding 13 months, the Fed had never allowed the actual rate to deviate from the target by more than 1 basis point. Although we can’t be sure until the next Federal Open Market Committee (FOMC) meeting on Tuesday, September 18, the behavior of the actual rate in August seems to suggest that the Fed will cut the target federal funds rate to at least 5.0%. A rate cut would mean that the Fed is backing away from a tighter policy stance associated with reducing inflation, and moving instead toward a more neutral monetary policy that will allow it to wait and see how the recent subprime and housing-market turmoil plays out in the broader economy.

The prospect of a rate cut raises the issue of moral hazard. Some critics feel that any loosening by the Fed will bail out borrowers who have taken on risky subprime mortgages and investors who have purchased the assets backed by such mortgages. By cutting rates, the Fed may encourage borrowers, lenders, and investors to make similar gambles in the future on the assumption that the Fed will intervene if things turn sour. Tyler Cowen’s latest New York Times column argues that while the Fed should not go out of its way to help poor decision makers, the Fed’s mandate—price stability and full employment—should not be sacrificed for fear of instigating moral hazard.

Discussion Questions

1. If banks become increasingly reluctant to lend to one another and to individual borrowers, what will happen to the types of consumption and investment expenditures that are typically financed by borrowing?

2. If borrowing difficulties persist for an extended period of time, what would you expect to happen to housing prices? What about economic growth? How should the Fed respond to this type of credit crunch?

3. Consider the borrowers, lenders, and investors who made poor decisions in the subprime market. Will some of them benefit from an FOMC decision to cut rates? Can the Fed prevent all moral hazard associated with monetary policy decisions? Can Fed policy provide total relief to the borrowers, lenders, and investors who made poor decisions in the subprime markets?

But what, if anything, can the fiscal authority—Congress and the President—do to assist the economy? According to Fed chair Ben Bernanke, “Fiscal action could be helpful in principle, as fiscal and monetary stimulus together may provide broader support for the economy than monetary actions alone.” (Read this New York Timesarticle for more.) However, Bernanke is hedging a bit here. By saying that tax cuts or spending increases “could be helpful in principle,” he implicitly acknowledges that such measures may be ineffective, or even harmful, in practice. The process of agreeing on and passing legislation limits the usefulness of fiscal policy for stabilizing mild fluctuations in economic output. By the time our representatives haggle over and pass legislation, the downturn may be over or the resulting policy may reflect political rather than economic considerations. For this reason and others, recent commentaries by Greg Mankiw and Robert J. Samuelson argue that we should leave the Fed to address mild ups and downs in the business cycle, reserving fiscal policy for deep or prolonged recessions.

Discussion Questions

1. Limitations of fiscal policy aside, Bernanke seems to understand that politicians seeking a track record to run on will often favor policy action over informed inaction. What advice does he give policymakers who are eager to implement fiscal policy?

2. Three specific types of “lag” may delay the beneficial effects of economic policies. The recognition lag is the time it takes us to figure out we’re in an economic pickle. We often don’t know that we’re in a recession until months after it’s started. The implementation lag is the time it takes policymakers to agree on and implement policies. The impact lag is the time it takes a policy to work its way through the economy and affect economic output and unemployment. For example, an increase in government spending on highway construction will show up as additional output over the entire life of the project, not all at once. How might these lag times differ between monetary and fiscal policy?

3. Plotting economic output over time reveals two basic observations: the smooth upward trend in output growth over the long haul, and the up-and-down wiggle of output in the short term. To paraphrase Aplia’s founder Paul Romer, it’s easy to lose sight of the trend for the wiggle. Policymakers can get so wrapped up in temporary economic tumults that they lose focus on the bigger picture. If we’re headed for recession, odds are that it will be mild by historical standards and the Fed will have plenty of policy ammunition to soften its adverse effects. Meanwhile, small changes in the long-run rate of economic growth have large impacts on future living standards. Given that, what policies would you recommend the action-minded fiscal authority focus on to improve the long-term growth prospects of the U.S. economy?

For more on the appropriate role of fiscal policy, listen to Bloomberg’s interview with Stanford economist John Taylor.

The Federal Open Market Committee (FOMC), the monetary policy arm of the Federal Reserve, announced a 50-basis-point reduction in the target federal funds rate on Tuesday, September 18. The stock market soared in response to the rate cut because most market watchers were only expecting a 25-basis-point reduction. Read the FOMC statement for the reasons behind the rate cut. After the announcement, the U.S. dollar decreased in value against the euro, the British pound, the Japanese yen, and the Canadian dollar. This was no coincidence, and the reduction in the value of the dollar actually reinforces the Federal Reserve’s goal of maintaining moderate economic growth.

The federal funds rate is a benchmark for other interest rates in the United States. For simplicity, let’s imagine for a moment that the federal funds rate is the only interest rate in the United States. If this is true, then the U.S. interest rate is also the dollar rate of return for holding U.S. assets. However, the United States is not the only country in the world. The European Union has its own interest rate that represents the euro rate of return for holding EU assets. For a given amount of volatility in asset prices, investors place their savings in assets that offer the best rate of return after adjusting for the exchange rate.

A reduction in the U.S. interest rate makes U.S. financial assets relatively less attractive than before because the EU interest rate has remained unchanged. U.S. investors will want to purchase more EU assets (i.e., there will be an increase in the supply of U.S. dollars), and EU investors will want to purchase fewer U.S. assets (i.e., there will be a decrease in the demand for U.S. dollars). Figure 1 shows the subsequent changes in the market for U.S. dollars.

A depreciation of the U.S. currency will make U.S. exports relatively inexpensive for foreigners while making imports from foreign countries relatively expensive for Americans. A decrease in the interest rate causes an increase in net exports and reduces the size of the U.S. trade deficit. Figure 2 shows the relationship between the exchange rate and net exports. Since net exports are a component of total spending in the U.S. economy, the Fed’s rate cut provides two boosts to aggregate spending: (1) the rate cut stimulates consumption and investment because the cost of borrowing decreases; and (2) the rate cut stimulates net exports due to U.S. dollar depreciation. By cutting the target fed funds rate, the Fed intends to prop up spending and growth at a time when tightening credit conditions threaten to slow or reverse the growth of economic output.

Discussion Questions

1. The previous analysis assumes that the United States and the European Union operate under a flexible exchange rate regime. Would the Fed be able to maintain moderate output growth after a severe shock, such as the subprime mortgage meltdown, if U.S. dollars were fixed to a currency such as the euro?

2. What if the Fed is wrong about the adverse effects of tightening credit conditions? What if growth would have continued at a moderate pace even without a rate cut? How would the decision to cut rates affect output and inflation in the short run and in the long run?

3. Suppose that at the next FOMC meeting on October 31, 2007, a jump in the inflation rate is reported. What would the FOMC do to the interest rate? How would this affect the exchange rate and net exports?

Wednesday, August 15, 2007

by William Chiu

World financial markets woke up to a rude surprise on the morning of Friday, August 10. The U.S. subprime mortgage debacle, which was originally thought to be well-contained within a small segment of the U.S. mortgage market, had spread to Europe. This was the straw that broke the camel’s back, especially after several hedge funds from highly reputable investment companies collapsed due to heavy reliance on mortgage-backed securities. Hearing this news, bondholders and stockholders were quick to sell their risky holdings in exchange for liquidity (also known as money), which is relatively stable in value.

Aside from the fact that a sudden spike in selling activity in financial markets reduces the paper wealth of investors, it could quite possibly reduce real wealth. First, let’s examine the money market effects of a sudden bond and stock sell-off due to a rise in risk aversion. For simplicity, we’ll assume there are only three forms of financial assets: bonds, stocks, and money. The sell-off raises the demand for money from MD1 to MD2, as shown in the diagram below.

If the central bank does nothing and fixes the money supply at MS1, the equilibrium interest rate increases from 5.25% to 10%. The economy moves from point A to point B.

Second, let’s examine the output market effects of a sudden bond and stock sell-off assuming that the central bank keeps the money supply constant. Higher interest rates mean a higher cost of borrowing for households and firms. Since big-ticket items such as automobiles, factories, and machinery are usually debt financed, consumption and investment spending (on physical capital) will decrease. Because consumption and investment spending are the two most important components of aggregate demand, a lack of central bank intervention will lead to a decline in aggregate demand from AD1 to AD2, as shown in the graph below.

If the central bank does nothing and fixes the money supply at MS1, the equilibrium interest rate increases, which reduces aggregate demand and causes a recession in the short run. The economy moves from point A to point B.

Third, let’s examine how central banks around the world reacted to the liquidity hoarding. As the New York Times put it, “central banks around the world acted in unison… to calm nervous financial markets by providing an infusion of cash to the system.” The Federal Reserve, along with most central banks, believes that fixing the interest rate is a better policy to maintain price stability and full employment. The Fed performed the cash infusion through of a series of government bond purchases known as open-market purchases, which is another term for the purchase of government bonds by the Fed. The cash infusion, or reserve injection, as textbooks call it, shifts the money supply curve from MS1 to MS2. The reserve injection effectively keeps the interest rate constant and avoids a recession.

If the reserve injection fails to calm financial markets and investors continue to hoard liquidity while selling bonds and stocks, central banks could inject additional reserves into the banking system through additional open-market purchases. The amount of money the Fed can create through purchasing government bonds is nearly limitless.

1. For the most part, the Federal Reserve’s main concern is first and foremost inflation, and secondarily unemployment. Given these two goals, should the Federal Reserve intervene every time the stock market takes a plunge?

2. Most economists believe that a permanent increase in the money supply will generate inflation and make the prices of everyday goods and services higher than they are today. Is this scenario likely given the large reserve injections in the U.S. and world money markets? Why or why not?

3. Some economists believe that markets are highly efficient in the sense that prices and interest rates adjust immediately to guarantee full employment. If this were true, would the Fed’s reserve injections have any effect on credit markets or the economy as a whole?

Wednesday, August 22, 2007

by Brandon Fuller

Rising foreclosures among homeowners with subprime mortgages led to unusually tight credit conditions in the banking system last week. Banks became reluctant to provide routine short-term loans to one another for fear that a borrowing bank’s balance sheet would be too heavily concentrated in shaky subprime loans. When banks are reluctant to lend to each other, they tend to make fewer loans to businesses and households. Liquidity—the ease with which banks lend to creditworthy costumers and institutions—began to dry up. On August 17, the Fed entered the fray.

In two press releases (here and here), the Fed acknowledged that recent reluctance to lend posed a threat to economic growth, and in a rare move, it encouraged banks with limited credit access to borrow directly from the Fed by lowering the discount rate. The discount rate is the interest rate at which banks borrow from the Fed. The Fed typically sets the discount rate 100 basis points (1 percentage point) above the rate at which banks lend to one another (the federal funds rate). On August 17, the Fed narrowed the spread between the discount and federal funds rates to 50 basis points—thereby reducing the penalty associated with borrowing from the Fed.

By lowering the discount rate, the Fed was fulfilling its function as the lender of last resort. To see why the Fed stepped in, it helps to consider how subprime fears might affect the availability of loans for creditworthy borrowers. Banks, especially large ones, often borrow in order to meet the Fed’s reserve requirement (the fraction of the bank’s deposits that must be held in reserve rather than being lent out). Without knowledge of which big banks will be affected by subprime foreclosures, other banks that would typically lend some of their excess reserves to big banks at the federal funds rate will be reluctant to do so. If large banks that are short on required reserves find it difficult to borrow reserves in the federal funds market, they will be forced to call in loans, and they’ll be hesitant to make any further loans. If banks call in loans and hesitate to lend to even creditworthy people and businesses, loan-dependent consumption and investment spending will fall, leading to slower economic growth, or worse, recession.

By reducing the discount rate, the Fed hopes to increase liquidity in financial markets by making it easier for banks to obtain short-term loans. If the policy works, creditworthy borrowers will not have any trouble obtaining loans for houses, cars, factory expansions, office buildings, and the like. As the subprime crisis subsides, regular credit conditions should prevail and the Fed will be able to return the spread between the federal funds rate and discount rate to its initial value of 100 basis points. If the credit crisis persists in spite of the discount rate move, the Fed will have to take stronger action. Read a recent Bloomberg column by John Berry to find out more.

Discussion Questions

1. In times of financial crisis, the Fed functions as a lender of last resort. More typically, the Fed’s role is one of economic stabilization—maintaining low and stable inflation as well as full-employment output. How does the Fed’s discount rate decision help it to fulfill its roles as lender of last resort and economic stabilizer?

2. Berry’s column mentions “moral hazard” several times. In what way does the Fed’s discount rate decision risk moral hazard?

3. Fears about losses from assets backed by subprime mortgages were at the root of much of the financial turmoil of recent weeks. According to Berry’s column, how do the estimated losses from the default of subprime borrowers compare to the total assets of the U.S. and Euro-area banking sectors?

4. If the credit crisis continues and economic growth suffers, how might the Fed respond?

5. According to Berry, “…growth may have been damaged even if [credit] markets do settle down relatively soon.” How would a temporary credit crisis damage economic growth? Consider the links between lending, housing prices, household wealth, and consumption, as well as the link between lending and investment.

When a central bank is “easing“, it triggers an increase in money supply by purchasing government securities on the open market thus increasing available funds for private banks to loan through fractional-reserve banking (the issue of new money through loans) and thus grows the money supply. When the central bank is “tightening”, it slows the process of private bank issue by selling securities on the open market and pulling money (that could be loaned) out of the private banking sector. It reduces or increases the supply of short term government debt, and inversely increases or reduces the supply of lending funds and thereby the ability of private banks to issue new money through debt. Note that while the terms “easing” and “tightening” are commonly used to describe the central bank’s stated interest rate policy, a central bank has the ability to influence the money supply in a much more direct fashion, as explained earlier in this paragraph.

Friday, August 24, 2007

by Chris Makler

As everyone learns halfway through their first principles of economics course, sometimes markets “fail.” Many economists argue, however, that the so-called failure of markets is just the reverse: it’s the fact that there aren’t enough active markets to reach an efficient outcome.

But can there be too many markets? Consider the latest problem with the housing market. In the good old days, when you took out a loan to buy a house, you had to convince the lender that you were creditworthy. After all, if you defaulted on your loan, they would be the one holding the bag. So they had a strong incentive to make sure that you could make your monthly payments.

This isn’t the way loans work anymore, thanks to a financial innovation called mortgage-backed securities. What happens is this: when a homebuyer takes out a loan from a bank, the bank bundles that loan with many other loans to create a kind of mutual fund—except that instead of containing stock from hundreds of companies, this fund includes the debts (mortgages) of thousands of homeowners. The idea is simple: as with any mutual fund, even if a single homeowner defaults, it has a negligible effect on the value of the overall fund. The fund’s price should reflect the overall risk of all the homeowners rather than the particular risk of any one homeowner.

This notion illustrates the concept of diversification—the fact that although one borrower may have considerable risk, much of that risk is unique, or diversifiable. A well-diversified portfolio of mortgages is only subject to systematic, or non-diversifiable, risk, and its value should reflect that. In other words, with a new kind of security and a market for it, the capitalist system becomes more efficient, because it spreads borrowers’ risk across a wide class of investors rather than concentrating it on single lenders (banks, in this case).

So what’s wrong with this picture? Think back to the initial lender. They know that they’re not making a long-term loan—all they’re doing is making a loan that they’re then going to sell in this new market. Once they’ve sold the loan, their exposure to the loan’s risk is over. Therefore, they have little incentive to see whether a homeowner can actually afford the payments, because they no longer bear responsibility for the credit decision. Quite the reverse, in fact: they have an incentive to sell the mortgage even if the homeowner cannot afford the payments—for example, by setting a low teaser rate that starts out fixed, but then balloons into a drastically higher variable rate. This has been one root cause of the various scandals about predatory lending practices that have been in the news in the last few months.

Discussion Questions

1. The crisis in the financial markets has caused some people to lose their jobs and made it harder to apply for a home loan, causing home sales to decline, both of which are very upsetting to Jim Cramer. Indeed, whenever a bubble bursts, lots of people get hurt, or at least find themselves considerably worse off than they were in the artificially inflated world of the bubble. Suppose you were a policymaker overseeing a market in which people were prospering in a way that was unsustainable. What would you do?

2. Cramer practically begged the Federal Reserve to intervene, which it did by lowering the discount rate (though not, presumably, because Jim Cramer asked it to). Does this get at the root cause of the problem? If not, what would?

3. How should society decide who gets to own a home and who does not? What would be the ideal set of institutions that could help achieve the optimal solution to such a problem? Could mortgage-backed securities play an important role in your solution?

Aplia founder Paul Romer was recently interviewed by Russell Roberts of George Mason University (you can find the podcast here). Some of the discussion revolved around Romer’s entry on economic growth in the Concise Encyclopedia of Economics.

As Romer points out in both the interview and the encyclopedia entry, small differences in the growth rate of income per capita lead to extraordinary differences in living standards over time. A simple formula allows us to consider the growth of average income over time, where n is the number of years and the growth rate is stated in decimal form:

(Initial per Capita Income Level) x (1 + Growth Rate)n

In the interview, Romer contrasts growth rates of 2.1% and 2.6% per year. For example, if U.S. income per capita is initially $30,000 and grows at a long-term rate of 2.1% per year, then after a period of 100 years, income per person will be approximately $30,000 x (1.021)100 = $240,000. How much higher would income per capita be after 100 years at a growth rate of 2.3% per year? What about 2.6%?

To achieve slightly faster income growth, an economy must be able to generate more new ideas and find applications for those ideas that result in more valuable products and services. As Romer points out, human history teaches us that economic growth springs from better ideas, not just from more output. Better ideas generate greater value per unit of input.

Discussion Questions

1. Consider the benefits of a simple idea Romer mentions in his encyclopedia article: the one-size-fits-all lid for coffee cups. How do you think this idea generated more value per unit of input for the coffee-cup manufacturer? What about the coffee shop?

2. According to Romer, “The knowledge needed to provide citizens of the poorest countries with a vastly improved standard of living already exists in the advanced countries.” What types of policies serve as barriers to the flow of ideas into poor countries? What types of policies might allow poor countries to take advantage of existing ideas and, as a result, contribute more new ideas of their own?

3. Faster growth and higher living standards depend in part on the strength of the incentives we face to generate and apply new ideas. When people can benefit from an idea without paying for it, the incentive to develop new ideas will be weaker. On the other hand, once an idea is discovered, not allowing it to be shared can be inefficient or even immoral. How do intellectual property rights, such as patents and copyrights, strengthen the incentive to discover new ideas? How might intellectual property rights hinder economic growth? Congress is currently considering reforms to patent laws in the United States. (A recent PC World article highlights the difficulty of designing patent laws that give inventors an incentive to develop new ideas while at the same time encouraging the rapid diffusion of new ideas at minimal cost.)

4. What, according to Romer’s piece, are meta-ideas? What meta-ideas have we used in the past to strengthen the incentives to develop new ideas?

Friday, July 27, 2007

by Victoria Miu

With persistent hyperinflation, money has become worthless in Zimbabwe. The official inflation rate in May was 4,500%, but according to estimates, the real rate had already reached 9,000%. In response to the continuously rising prices, President Mugabe of Zimbabwe ordered the prices of all commodities be cut by at least half. This type of price control by the government is referred to as a price ceiling, with the selling price set below the equilibrium price. Let’s examine the effect of a price ceiling using the supply and demand diagram to the right.

Let Pe and Qe be the equilibrium price and quantity of a commodity. A price ceiling that regulates the commodity to be sold at Pc leads to an increase in quantity demanded to Qd. At the same time, producers reduce the supply of the commodity at Pc, thereby lowering the quantity supplied to Qs. Hence, there will be excess demand, or shortage (Qd – Qs) for the commodity. This is exactly what the Zimbabweans are experiencing in the wake of Mugabe’s price cuts. Many commodities were swept from the shelves and disappeared from sale as producers refused to supply more at the regulated price.

The story does not end here, though. From the supply and demand model, we see that at Qs, some people are willing to pay as much as Pb to obtain the commodity. Therefore, informal markets emerge with people buying and selling commodities at prices much higher than the regulated or market equilibrium prices.

Thursday, June 07, 2007

by Nicholas Smith

I was deep in conversation with my 14-year-old son regarding the relative costs and benefits of wearing a helmet while skateboarding. Guess which side I was on? We were driving from the Bay Area to Davis, California, for Memorial Day weekend. Deep into the task of convincing my son that the various monetary, emotional, and intellectual costs of brain surgery far outweighed the relatively minuscule cost of looking slightly uncool when wearing a helmet, I stopped to pay the toll at the Carcinas Bridge. I reached out to hand the toll taker my $4, but to my astonishment, he waved me off, saying, “The car in front of you paid.” Have you ever had that sinking feeling in your stomach when you’ve done something wrong? I was feeling exactly the opposite! I felt like I had just won some mini-lottery. It changed my whole perspective on the day. I even ignored my son’s wisecracks about my having ruined his social life by imposing the helmet “law” on him.

Now, I could have attributed this event to some random act of kindness: certainly commendable, but anomalous nonetheless—except that this was the third time it had happened to me in the last 12 months. In economic terms, this doesn’t seem to add up. Why would so many people pay the toll for complete strangers with no hope of a return on their investment? How did it start? What was the incentive? Who was philanthropist zero? And what of the positive repercussions this created for the rest of the community? What other acts of kindness did this generate?

If economics is about people acting in their own self-interest, does this make sense? Maybe it makes complete sense. Perhaps people are motivated by the personal gratification they derive from their own generosity rather than the desire to make others feel good. In fact, anonymous acts of kindness allow us to imagine that we’ve done some amount of good that might be far in excess of reality. In that sense, $4 is a small price to pay for a momentary feeling of supreme virtue.

Thus, to some degree, acts of kindness are reciprocal—we aren’t giving something for nothing. When we pick up someone else’s toll or leave extra money in the parking meter, we magnanimously give up a small amount, but we potentially receive a powerful feeling of satisfaction in return. None of this is to say that the effects of this type of behavior are undeniably positive, simply that the motives involved may have more to do with self-interest than with pure altruism.

Economist Steven Landsburg offered his take on the economics of altruism a few years back in an interesting article in Reason magazine. Check it out here.

Discussion Questions

1. What happens in Vernon Smith’s envelope experiment when participants are told that their actions are anonymous? What happens in the experiment when participants are told that researchers will track individual decisions?

2. In the James Cox version of Smith’s envelope experiment, donated sums are automatically tripled. How does the behavior of participants change under this scenario? Why, according to Landsburg, is this evidence of something dark and disturbing about human nature?

3. What could the Cox experiment teach charitable organizations about techniques for raising money?

Monday, May 21, 2007

The People’s Bank of China announced on May 18 that it would allow the yuan to float within a 0.5% band around a government-imposed exchange rate. For example, if the government-imposed rate were 7.6938 yuan per U.S. dollar, the central bank would allow the exchange rate to fluctuate between 7.6553 and 7.7323 yuan per U.S. dollar. Due to a soaring economy and a widening trade surplus with the United States, the yuan closed at a record high of 7.6686 yuan per U.S. dollar on the first day of the new exchange rate policy. In other words, after the announcement, the yuan strengthened against the U.S. dollar.

A “stronger yuan” means that 1 yuan can purchase more U.S. dollars than before. If the exchange rate were 1 yuan per U.S. dollar, yuan holders could obtain $1 for each yuan exchanged. If the exchange rate fell to 0.5 yuan per U.S. dollar, yuan holders could obtain $2 for each yuan exchanged. Hence, the yuan gets stronger as its exchange rate falls, and is stronger at 7.6686 than at 7.7323 yuan per U.S. dollar.

The stronger yuan makes Chinese products more expensive for Americans, reducing net exports and therefore lowering China’s real GDP growth rate. Why would the People’s Bank of China want to destroy jobs in its exports sector by favoring a stronger yuan? One popular explanation is that the Chinese government is giving in to U.S. political pressure to strengthen the yuan. A stronger yuan would reduce the U.S. trade deficit with China, boosting American goodwill towards China and avoiding the passage of U.S. restrictions on Chinese imports.

There is also an economic explanation for China’s new exchange rate policy. Along with China’s recent double-digit economic growth comes the prospect of high inflation and economic instability. The standard monetary policy remedy for an overheating economy is higher interest rates. Raising the cost of borrowing reduces overzealous consumption and runaway investment spending. Furthermore, higher interest rates attract more foreign investors, raising foreign demand for Chinese currency, which strengthens the value of the yuan. At the same time, higher interest rates encourage Chinese investors to keep more of their yuan in Chinese assets, leading to a reduction in the supply of yuan, which adds additional upward pressure on the value of the yuan.

Therefore, the People’s Bank of China faces an economic dilemma. If it wants to tame the roaring economy, it must allow the yuan to strengthen. But if it wants to maintain a fixed exchange rate, it would need to keep the interest rate unchanged. Today, the central bank has chosen economic stability over exchange rate stability.

Discussion Questions

1. The central bank coupled the exchange rate announcement with a Q&A document for the public. In what ways is the central bank’s explanation for widening the exchange rate band similar to our analysis? In what ways is it different?

2. Why would the central bank hesitate to allow the yuan to float freely? In other words, what are the drawbacks of immediately eliminating exchange rate controls?

3. For some time, U.S. policymakers have complained about China’s exchange rate policy. How would a weaker U.S. dollar affect American consumers of Chinese products? How would a weaker dollar affect American producers who compete with Chinese producers? How would a weaker dollar affect Chinese consumers of American products and American firms that export goods to China?

JANUARY 29, 2009

Chinese Yuan– When a consumer in the US buys a Chinese product, Chinese manufacturers are paid in US dollars. These US dollars are then deposited in the a Chinese bank account. At this point the local Chinese bank needs to converts the US dollars into yuan. The bank does this by selling the US dollar to the Chinese central bank, the People’s Bank of China. Since the trade between the US and Chinese does not balance, there is a shortage of yuan, and a surplus of US dollars in the Chinese central bank. Under normal rules of international trade, the Chinese central bank should sell its US dollars on international markets, and buy yuan in exchange, resulting in a self-correcting system where a the US dollar weakens, and the Chinese yuan strengthens until equilibrium is restored and the trade gap closes. However, in order to avoid this situation, the Chinese central bank bends the rules by taking the excess dollars inflows and sterilizes them by buying US denominated assets, such as US Treasuries. This has the effect of removing the excess dollars from currency exchange markets where they can cause a correction in the exchange rates. Thus, instead of using the US dollars to buying yuan on the international currency market, the Chinese central bank manipulates the exchange rates by creating yuan, and buying US debt. This “printing” of Chinese Yuan by the central bank is not with out consequence, however, since in excess it will eventually lead to inflation, causing the consumer prices to rise.]

Chinese Premier Wen Jiabao squarely blamed the U.S.-led financial system for the world’s deepening economic slump, in the most public indication yet of discord between the U.S. government and its largest creditor.

Leaders in China, the world’s third-largest economy, have been surprised and upset over how much the problems of the U.S. financial sector have hurt China’s holdings. In response, Beijing is re-examining its U.S. investments, say people familiar with the government’s thinking.

Mr. Wen, the first Chinese premier to visit the annual global gathering of economic and political leaders in Davos, Switzerland, delivered a strongly worded indictment of the causes of the crisis, clearly aimed largely at the United States though he didn’t name it. Mr. Wen blamed an “excessive expansion of financial institutions in blind pursuit of profit,” a failure of government supervision of the financial sector, and an “unsustainable model of development, characterized by prolonged low savings and high consumption.”

Chinese leaders have felt burned by a series of bad experiences with U.S. investments they had believed were safe, say people familiar with their thinking, including holdings in Morgan Stanley, the collapsed Reserve Primary Fund and mortgage giants Fannie Mae and Freddie Mac. As a result, the people say, government leaders decided not to make new investments in a number of U.S. companies that sought China’s capital. China’s pullback from Fannie and Freddie debt helped push up rates on U.S. mortgages last year just as Washington was seeking to revive the U.S. housing market.

To be sure, China’s economy now is so closely intertwined with the U.S.’s that major, abrupt changes are unlikely. The U.S.-China economic relationship has become arguably the world’s most important. China has been recycling its vast export earnings by financing the U.S. deficit through buying Treasurys, helping to keep U.S. interest rates low and give American consumers more spending power to buy Chinese exports.

China now has roughly $2 trillion in foreign exchange reserves, and has continued to buy U.S. government debt — surpassing Japan in September as the biggest foreign holder of Treasurys, by one official U.S. measure. China must continue to recycle its trade surplus if it doesn’t want its currency to appreciate too quickly.

Still, the relatively smooth financial ties between the two powers that underpinned the global economic boom of recent years are being tested. As both sides survey the wreckage of the U.S. housing bubble and credit crunch, mutual recriminations are raising doubts about the relationship.

The Chinese premier’s remarks came a few days after Treasury Secretary Timothy Geithner fanned the flames when he accused China of “manipulating” its currency during his confirmation process. That was widely seen as an escalation of long-standing U.S. complaints that China artificially depresses the value of the yuan to bolster its exports, and prompted strong denials from Beijing. The Obama administration has since played down the statement’s significance.

More Friction

Frictions between the two countries began to worsen long before Mr. Obama took office. The Chinese central bank last year stopped lending its Treasury holdings for fear the borrowers will go bankrupt, according to people familiar with the discussions — a decision that disrupted the functioning of the Treasury market. Beijing rejected pleas by Washington to resume its lending of Treasurys, the people said.

Meanwhile, China — for years the largest foreign investor in bonds from Fannie Mae and Freddie Mac — has been sharply trimming its holdings of that debt. After making direct net purchases of $46.0 billion in the first half of 2008, China’s government and companies were net sellers of $26.1 billion in the five months through November, according to the latest U.S. data.

Weak demand for such debt from China and other foreign investors helped prompt the Federal Reserve to announce in November that it would take the step of buying up to $600 billion in debt from Fannie, Freddie and two other U.S. government-related mortgage businesses.

While Chinese officials have generally been circumspect in public, some Chinese commentators have sharpened their rhetoric in recent weeks. Washington “should not expect continuous inflow of more cheap foreign capital to fund its one-after-another massive bailouts,” said a December editorial in the government-owned, English-language China Daily. Officials at the newspaper said the commentary wasn’t ordered by the government.

Cash-rich Chinese financial institutions are under withering criticism at home for investments in the West that have lost money, such as a $5.6 billion stake in Morgan Stanley purchased by China’s sovereign wealth fund, China Investment Corp., 13 months ago. The U.S. company’s shares have dropped around 60% since then. Chinese institutions have rebuffed entreaties to invest in struggling U.S. companies even as investors from Japan and the Middle East have stepped up.

Chinese Premier Wen Jiabao

For years, Washington has pushed China to adopt an economic and financial system more like that in the U.S. — arguing, for example, that China should liberalize capital flows in and out of the country. In many cases, China has moved more slowly than the U.S. desired. Beijing has resisted American pressure to let its currency appreciate in line with market forces, for example, which economists say has helped inflate China’s trade surplus.

But often, U.S. suggestions had a sympathetic audience among reformers in China’s government, and many of China’s financial overhauls in recent decades have been inspired by the U.S. model. Now, some of these changes, and their proponents, have lost credibility in China in the wake of the financial meltdown, and recently commentators and officials in China have been increasingly critical about Washington.

Amid high-level Sino-U.S. economic talks in Beijing in early December, Chinese officials admonished the U.S. and Europe for their financial governance.

Vice Premier Wang Qishan, China’s top finance official, called on the U.S. to “take all necessary measures to stabilize its economy and financial markets to ensure the security of China’s assets and investments in the U.S.”

A similar complaint was issued by Lou Jiwei, chairman of CIC, the government fund established in 2007 to seek higher returns on a $200 billion chunk of China’s currency holdings. Mr. Lou said in a December speech that he has “lost confidence” because of inconsistent government policies concerning support for Western banks. “We don’t know when these institutions will be invested in by their governments,” he said.

Fate of U.S. Investments

CIC officials are especially sensitive about the fate of their U.S. investments because they have been under fire for the poor performance of earlier deals. CIC has sustained large paper losses on the $3 billion it invested in Blackstone Group LP in June 2007, as well as the Morgan Stanley stake. Staffed by officials, some western-educated, who have helped promote financial-market liberalization in China, CIC is also viewed by some Chinese as a symbol of the country’s close financial ties to the U.S. — another reason it has been in the crosshairs.

Around October, a lengthy Chinese-language essay began circulating on the Internet excoriating Mr. Lou and other top CIC officials, along with Zhou Xiaochuan, China’s central bank governor, for being too close to the U.S. and then Treasury Secretary Henry Paulson. The diatribe quickly gained wide circulation in Chinese financial circles. One passage charged that Mr. Zhou “colluded with Henry Paulson to buy U.S. bonds, forced [Chinese yuan] appreciation, attached China’s economy to the U.S. and broke China’s economic independence.”

Chinese and U.S. interests remain deeply enmeshed. Washington’s huge stimulus plans will result in even heavier borrowing, and, while rising savings in the U.S. could create more domestic capital to help fund that, Chinese lending will remain important.

Japan investors, too, have been selling Fannie and Freddie debt and making other moves to limit their U.S. risk. An official at another Asian central bank in charge of managing hundreds of billions of dollars in foreign exchange reserves noted late last year that trading in some derivative instruments had factored in a slightly higher possibility of default by the U.S. government, though that prospect is still viewed by most investors as extremely low.

The alarm for Chinese leaders started ringing loudly in July and August as problems deepened at Fannie and Freddie. Senior Chinese leaders, who hadn’t been apprised in detail of how China’s reserves were being invested, learned for the first time in published reports that the country’s exposure to debt from those two alone totaled nearly $400 billion, say people familiar with the matter.

Fearing that the U.S. government might not fully back the companies, China demanded and received regular briefings throughout the peak of the crisis from high-level Treasury Department officials, including Mr. Paulson, on the market for U.S. debt securities — especially those of the mortgage giants.

Mr. Paulson and other Treasury officials spoke regularly with Vice Premier Wang and other senior Chinese officials to soothe their concerns.

The World Economic Forum in Davos was full of verbal tongue-lashings for the U.S. from countries such as Russia and China. The world is calling for the U.S. to get its act together. Video courtesy of Reuters.

Hit With Questions

Chinese officials often bombarded their U.S. counterparts with questions, according to people who were present at meetings.

While Mr. Paulson was in Beijing for the Olympics in August, he dined with Mr. Zhou, the central bank chief, at the Whampoa Club, an upscale restaurant that serves modern Chinese cuisine in a traditional courtyard building near the city’s Financial Street.

On Sept. 7, Mr. Paulson announced that the U.S. government would seize Fannie and Freddie, but Chinese officials remained concerned.

At one briefing for Chinese officials to explain the change, said people present, they questioned and debated the meaning of nearly every line of the new Treasury plan.

Then Washington allowed Lehman Brothers Holdings Inc. to collapse, further shaking Beijing’s faith. One casualty was CIC’s nearly $5.4 billion investment in the Reserve Primary Fund, the money-market fund that “broke the buck” in September as a result of the Lehman collapse.

CIC had placed money in the Primary Fund because “money market funds are supposed to be very safe,” said a Chinese official in an interview late last year. But on Sept. 16, the Primary Fund’s managers announced that they were delaying redemptions.

CIC officials emailed Reserve asking to withdraw all of its money from the fund, and promptly received a reply agreeing to the request, says the Chinese official.

CIC officials believed the agreement meant that CIC had become a creditor to the troubled fund, and therefore was entitled to all of its money.

A Reserve spokeswoman says the company doesn’t comment on individual clients.

Later in the day on Sept. 16, Reserve announced that the Primary Fund’s net asset value had fallen to 97 cents a share, below the standard $1.00 level.

Reserve initially said redemption requests received before 3 p.m. that day would be honored in full, but has since said that the net asset value already was down to 99 cents a share by 11 a.m.

As Reserve further delayed payments, CIC began to fear that it might not get all of its money.

The Reserve issue “is causing a lot of concern with a lot of financial institutions in China,” said the Chinese official.

Some officials expected that the U.S. and its financial institutions would better protect China from loss.

“If the U.S. is treating us this way, eventually that will be enough cause for concern in the stability of the [U.S.] system,” the official said.

A CIC spokeswoman declined to comment on the current status of the dispute.